Due Diligence for Prospective Franchisees

What type of due diligence, investigation or validation should a prospective franchisee perform? A prospective franchisee, someone looking to invest in a franchise, should learn as much as possible about the business and franchise opportunity prior to signing any contract or paying any money to the franchisor. First and foremost, read the 23 items of the FDD. This document is supposed to be written in “plain English” for a prospective franchisee’s review. Pay particular attention to Items 5, 6 & 7, the financial disclosures. In addition, review Item 20 to learn about the system and its anticipated growth.

One of the most important steps to take is to speak to as many franchisees and former franchisees that you can. The names and contact information for these franchisees and former franchisees are listed as an exhibit to Item 20 of the FDD (Franchise Disclosure Document). These franchisees and former franchisees can be a very valuable resource in learning about the franchise, the support and training a franchisee receives, both initially and on an on-going basis, and whether the franchisees are happy in the system. A system that is filled with unhappy franchisees is generally not a good system with which to associate. Unhappy franchisees usually indicate that there are greater issues and problems with a franchise system. In my experience the system with unhappy franchisees is a system from which a prospective franchisee should walk away.

Another important step is to make sure that the franchisor is financially strong enough to support both the system that is in place and the growth that is anticipated.  Item 20 of the FDD discloses the number of corporate and franchised locations a franchisee has and how many more they anticipate adding.  Based on the Item 20 disclosure and other factors, a good business accountant, preferably one with franchise experience, is able to review the audited financial statements included in the FDD and determine if this franchisor is financially strong. If the analysis concludes that a franchisor is weak, a prospective franchisee should walk away.

Another step in evaluating a franchise opportunity is to see if you can work in the franchise for a day or a few days to determine if you like the business.  This is a long-term commitment to develop a business and you wouldn’t want to enter into it and then find out you don’t like the business.

Lastly, but not least, it is important as part of the due diligence or validation, to have the franchise documents (FDD and franchise agreement) reviewed by an experienced franchise attorney.  This review is important even when a franchisor will not negotiate the franchise documents (in our experience, even those franchisors who state they don’t negotiate the franchise agreement will agree to a few modifications by way of an addendum to the franchise agreement). It is also important even if the prospective franchisee is an experienced business person. Franchise documents are not easily understood or evaluated by individuals, even other attorneys, who do not read them on a daily basis and understand what is of concern and what is typical. Franchise law is very regulated, both federally and by many states, and is constantly evolving. It is important before someone invests their time and money into a franchise, to have the FDD and franchise agreement reviewed by someone who handles these types of franchise documents routinely. Over the years of representing prospective franchisees we have represented very experienced business people as well as other attorneys, all of whom have concluded that our process helped them in deciding whether this opportunity was right for them.

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